Investment bank buyouts multiply

Promise of big profits is trumping potential for conflicts and losses

By

AlistairBarr

SAN FRANCISCO (MarketWatch) -- Instead of just advising on and arranging financing for private-equity buyouts, investment banks are increasingly doing the deals for themselves.

In just one of the latest notable examples, Goldman Sachs
GS, -1.86%
on Monday joined with TPG Capital in an agreement to buy Alltel Corp.
AT, +0.00%
the nation's fifth-largest wireless-phone service carrier, for $27.5 billion in what would be the largest leveraged buyout ever in the U.S. telecommunications industry.

'It's a high-return business. Goldman is the expert at coining money from these businesses.'
Brad Hintz, Bernstein Research

At the same time, Merrill Lynch
MER, -2.00%
took another step into the private-equity business too, when it bought a minority stake in GSO Capital Partners, an $8 billion hedge fund firm that helps private-equity companies finance deals.

The moves give Goldman and Merrill the chance to make much more money. But they also expose them to potential client conflicts and investment losses.

"The history of private equity at brokerage firms has been an on-again, off-again love affair," said Brad Hintz, an analyst at Bernstein Research and a former chief financial officer at Lehman Brothers.

During the 1980s boom in leveraged buyouts, major investment banks piled into acquisitions of their own, only to step back in the 1990s as they found themselves in conflict with their clients. It was for that reason, Hintz said, that Merrill dropped out of the business.

After the technology market blew up in 2001, brokerage firms saw a sharp retreat in earnings because they'd made private equity investments in tech companies. But since then, low interest rates and rising cash on corporate balance sheets has sparked an unprecedented private-equity boom that's made it difficult for investment banks to merely watch from the sidelines.

Top advisory candidate

One of the most alluring aspects of the business for firms like Goldman is that an in-house private-equity unit promises to boost investment banking revenue down the road. By taking an equity position, the bank instantly becomes the company's top candidate to become its adviser on any future underwriting or merger-advisory work in the future -- even though a competing brokerage might charge lower fees.

By Hintz's estimate, an investment bank gets a return of 40 cents in banking fees for every $1 it puts into a private-equity deal.

Here's how it works: Imagine you're chief executive of an industrial company that's just been acquired by Goldman Sachs's private-equity unit. They now own your company.

"Who are you going to use as an M&A adviser, and how aggressive are you going to be negotiating fees?" Hintz said.

New regulations are also encouraging investment banks to put more of their own money into buyouts.

The upcoming Basel II accord requires less capital to be set aside to support private-equity investments. That is allowing banks like Goldman and Merrill to hold more private-equity investments on their balance sheets, Hintz explained.

The success of Goldman's private-equity unit also shows how profitable these businesses can be for Wall Street banks. The company has invested in more than 500 companies and more than $19 billion in capital has been committed to its buyout business since it began in 1983, according to Bernstein research.

In 2005, Goldman raised $8.5 billion for a private-equity fund, which at the time was the most money ever committed to a buyout fund. Several other private-equity firms have since topped that, but the fund remains among the 10 largest, according to Thomson Financial data.

Roughly one-quarter of the money came from Goldman and its employees.

Goldman's private-equity assets under management probably stood at roughly $19 billion at the end of 2005 and the bank generated management fees of about $220 million to $225 million that year, according to a Bernstein report in May 2006.

'Override' fee

With its buyout funds, Goldman tries to generate an internal rate of return of between 25% and 35%. In addition to investment returns and management fees, Goldman also collects an "override" fee, which is 20% of net gains when returns for the funds' outside investors rise above about 8% a year, Hintz said.

If Goldman manages to collect this 20% fee, further gains are shared, with 80% going to outside investors and 20% to Goldman, the analyst added.

"It's a high-return business," Hintz said. "Some are gold mines. Goldman is the expert at coining money from these businesses."

Other private-equity fees are charged too. Companies owned by private-equity firms usually pay a management fee of around 0.5% of annual revenue. Then there are advisory fees from the acquisition, bank syndication fees when companies' loans are refinanced, and sale or merger fees when the buyout firm unwinds its investment, Hintz said.

In 2005, Goldman's private-equity business probably had a pretax profit margin of 50%, Bernstein estimates. That's higher than its overall profit margin, which stood at 33% in 2005. The unit accounted for 5.3% of the bank's revenue and 8.2% of profit in 2005.

Losses, conflicts

But buyouts can produce investment losses too. From 2000 to 2002, Goldman's private-equity investments fell by 65%, Bernstein said, although the research firm noted that this was partly because the bank exited some holdings.

When an investment bank builds a big private-equity business, its risks conflict\ with other major private-equity players.

Goldman missed out on being named one of the underwriters for the upcoming initial public offering of Blackstone Group, one of the largest private-equity firms in the world.

Bernstein's Hintz said that's a good example of how investment banks can end up competing against potential clients when they develop their own large private-equity businesses.

"Private-equity firms are major, major clients of Wall Street and many brokerage firms are reluctant to compete with clients," he said, while noting that "Goldman has certainly been able to walk that fine line."

As these deals proliferate, they also have aroused controversy because they increase the likelihood that the firm would become both an adviser a potential bidder for a company that is up for sale.

Merrill Lynch, which has the second-largest private equity portfolio of any U.S. investment bank behind Goldman, often forms partnerships with other buyout firms. That reduces the potential for competitive conflicts but also cuts the fees and ultimate profitability of its business, Hintz said.

Still, buyouts were a big contributor to Merrill's earnings in 2006. Bernstein estimates that the business contributed 5% to 6% of the firm's revenue and more than 15% of its profit last year.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.